- These hybrids are a rehash of earlier offers
- We analyse them using two different methods
- For our Conservative Portfolio, we’ll stick with the investments we’ve got
It’s been a while between drinks, but NAB and AMP have the advisors back on the phones selling two new hybrid issues –Maximum Conversion Number) are important. They highlight the fact these products aren’t fixed interest securities (which put an obligation on issuers to pay interest and repay principal). The NAB CPS 2 are complicated quasi-equity securities with debt-like features and the AMP Sub Notes 2 are quasi-debt securities with equity-like features.
Allocating the hybrids
Where do you fit such securities into an investment portfolio? As they’re typically pitched to conservative income-focused investors, we’ll use our Conservative Portfolio as a case study.
The target asset allocation for our Conservative Portfolio is set out in Chart 1. As you can see we don’t have a target allocation for hybrids, junk bonds or quasi-equities with debt-like features. We suspect the average investor is in the same boat.
Investing is complicated enough without having a ‘funky structured products or other esoteric investments’ asset class. So let’s consider them in the context of the asset classes we’ve got. Where do they fit?
We take a risk-based approach to asset allocation and, in particular, we aim to keep our fixed interest and cash ‘safe’. Risk is for the growth part of the portfolio (shares, property and infrastructure and other).
If we had to allocate hybrids to one asset class it would be ‘Australian shares’ (although you could mount an argument for ‘property and infrastructure’ given their relatively fixed return and the exposure of the finance sector to residential property). It’s a conservative way to tackle the issue and avoids us mistaking the risk on NAB CPS 2 for that of a low-risk Government guaranteed deposit or other highly rated debt security. They’re just not safe enough for us to allocate to ‘Australian fixed interest’.
Looked at from this perspective, it’s easy to give them the flick. Unless there’s a sudden spike in interest rates, NAB CPS 2 is offering a return of less than 6% and AMP Sub Notes 2 less than 5.5%. We’d hope to do better out of our shares and other risk assets than that.
Splitting them up
That’s a simple approach but we can get a bit more scientific, since these hybrids, whilst lacking some key ingredients of fixed interest, generally aren’t as risky as ordinary shares. So it makes sense to split them between the two asset classes. How should we go about this task?
It’s more art (or guesswork) than science, since so much depends on your point of view when it comes to assessing hybrids. During the global financial crisis, the market for many of the bank hybrids found a floor at around 60% of their issue price (see Chart 2) and, if NAB skipped the dividend payments on NAB CPS 2, the present value of the conversion proceeds (assuming mandatory conversion occurs) is also around 60% of the face value. Add in a touch of conservatism and we’d allocate 50% of the NAB CPS 2 to fixed interest – the rest (the ‘equity piece’) we’d allocate to shares.
The AMP Sub Notes 2 are a safer security (hence their lower return) so we’d allocate a larger amount to fixed interest. As we explained in volatility. But we’re focused on what we’re giving up if we invest in hybrids (our opportunity cost) and that’s why we give them the flick at today’s prices. If hybrid prices fell, pushing returns higher, we might reconsider that position.
Final word on hybrids
Whether we use the simple approach (treating hybrids as a risk asset), or split them in two, the end result is that the returns aren’t compelling compared to our current investments. Hybrid returns look attractive compared to term deposits, or low-risk bond funds, but that’s simply because investors aren’t factoring in the significant added risk.
When we add risk to our Conservative Portfolio it will be because we’ve identified an opportunity (and value), not because a broker’s email happened to land in our inbox.